Should you worry about the composition of Sensex?

Recently it was announced that Lupin and Cipla would be removed from the Sensex. Often retail investors panic or get confused about the stocks that are excluded from the benchmark indices. Do they have to base their investment decisions solely on the inclusion or exclusion of individual stocks from the indices?

Broad equity indices act as a barometer of market direction and indicate the magnitude of changes in the overall market values based on a sample of stocks. However, neither all stocks in the indices guarantee wealth creation nor all stocks removed lead to wealth destruction. By nature of the index, successful stocks (in terms of market cap build-up) are regularly added and temporarily failed ones, in relative terms, are excluded.

For instance, when the global deflationary pressures were peaking , in November 2015 both Vedanta and Hindalco were removed from the Sensex. However, these two stocks saw their market caps, rising over 300% and 260% respectively from the date of exclusion to as of date. In the same period, the market cap of Sensex moved up 30%. More recent example is of GAIL. This stock was excluded from the Sensex on May 19, 2017 – since then its market cap has moved up 16%, while the market cap of all BSE-listed stocks rose only 10%.

Interestingly, at the peak of the bull run in real estate, DLF was included in the Sensex in November 2007, and in June 2012 it was excluded. During this period of its inclusion to exclusion, DLF lost 80% of its market cap.

It is true that many constituents of broad indices do create a lot of wealth in the long term. However, it is equally true that mega wealth creation happen outside broad indices also. This is realistic for the Indian markets as our country has got the highest number of listed stocks in the world. In India, for instance, only after they emerged as quite large cap stocks, Infosys and Wipro were included in the broad indices.

Of course, the broad indices are highly useful to know the market directions and overall valuation on a sample basis. They are also useful for the passive investors to invest in any markets through ETF routes and for hedging the individual portfolios against market volatility.

For retail investors, who believe in individual stock picking, it is the individual merit of the stocks on fundamental basis rather than inclusion or exclusion would matter for wealth creation.